Financial Statements and Reports

1
Financial Statements and Reports

• Financial reporting is used to disclose
  information about the firm
• Financial statements provided to
• stockholders/creditors
• SEC
• IRS
• Management
• Annual reportincludes
• a general discussion about the firms activities
  during the past year and expectations in the near
  future
• financial statements of the firm for the most
  recent years

2
Income Statement

• Provides a summary of the revenues recognized and
  the expenses incurred during a particular
  operating period.
• Matching principlerevenues are recognized when
  sales occur (earned) and expenses are realized
  when they are incurred.
• Accrual accounting versus cash flows

3
Balance Sheet

• Records the financial position of the firm at a
  particular point in time by showing the
  assetsthat is, the investmentsand the
  liabilities and equitythat is, the financingof
  the firm.
• Historical costs

4
Balance Sheet

• Cash versus other assetsonly cash represents
  actual funds that can be invested
• Liabilities versus stockholders equity
  liabilities represent debt, whereas equity
  represents ownership
• Preferred versus common stockall corporations
  have one type of stock called common stock some
  firms have equity called preferred stock

5
Balance Sheet

• Common equity accounts
• common stock number of shares outstanding times
  the par value of each share
• paid-in capital amount above the par value for
  which common stock was issued
• retained earnings income the firm earned in the
  past that was retained and reinvested in assets
  

6
Statement of Retained Earnings

• Shows the change in the retained earnings and
  common equity accounts since the last balance
  sheet was constructed.

7
Statement of Cash Flows

• Reports the effect of the firms
  activitiesoperating, investing, and
  financingover some period on its cash position

8
Statement of Cash Flows

• Income versus cash flowsrevenues and expenses
  are recognized when incurred, not when cash is
  received or paid
• Non-cash itemssome non-cash items appear on the
  income statement, such as depreciation
• Accounting profitnet income, or the bottom
  line on the income statement net income and
  cash flows generally are highly correlated
• Operating cash flowscash flows generated from
  the normal operating activities of the firm

9
Statement of Cash Flows
Simple rules to follow when constructing a
statement of cash flows Sources of Cash Uses of
Cash ? Liability Account ? Liability
Account (e.g., borrow more) (e.g., payoff
loans) ? Equity Account ? Equity Account (e.g.,
issue stock) (e.g., pay a dividend) ? Asset
Account ? Asset Account (e.g., sell
inventory) (e.g., purchase equipment)

10
Eagle, Inc. Income Statement
Sales 80,000 Variable operating
costs (60,000) Fixed costs, excluding
depreciation (12,000) Depreciation ( 2,000) EBIT
NOI 6,000 Interest ( 1,000) Earnings before
taxes (EBT) 5,000 Taxes (40) ( 2,000) Net
income 3,000 Dividends 2,000 Addition to
retained earnings 1,000
Sales 80,000 Variable operating
costs (60,000) Fixed costs, excluding
depreciation (12,000) Depreciation ( 2,000) EBIT
NOI 6,000 Interest ( 1,000) Earnings before
taxes (EBT) 5,000 Taxes (40) ( 2,000) Net
income 3,000 Dividends 2,000 Addition to
retained earnings 1,000
Sales 80,000 Variable operating
costs (60,000) Fixed costs, excluding
depreciation (12,000) Depreciation ( 2,000) EBIT
NOI 6,000 Interest ( 1,000) Earnings before
taxes (EBT) 5,000 Taxes (40) ( 2,000) Net
income 3,000 Dividends 2,000 Addition to
retained earnings 1,000

11
Eagle, Inc. Balance Sheet
Current Current Year Year Cash
securities 2,000 Accounts payable
4,000 Accounts receivable 6,000 Accruals 5,000
Inventory 7,000 Notes payable 1,000
Current assets 15,000 Current
liabilities 10,000 Net fixed assets 10,000
Long-term debt 6,000 Total assets 25,000
Total liabilities 16,000 Common
stock 6,000 Retained earnings 3,000
Owners equity 9,000 Total liabilities
equity 25,000
Current Previous Current Previous Year
Year Year Year Cash securities
2,000 1,000 Accounts payable 4,000
2,000 Accounts receivable 6,000 5,000 Accruals 5,0
00 4,000 Inventory 7,000 8,000 Notes
payable 1,000 2,000 Current
assets 15,000 14,000 Current liabilities 10,000 8
,000 Net fixed assets 10,000 9,000 Long-term
debt 6,000 7,000 Total assets 25,000 23,00
0 Total liabilities 16,000 15,000 Common
stock 6,000 6,000 Retained earnings 3,000
2,000 Owners equity 9,000 8,000
Total liabilities
equity 25,000 23,000

12
Eagle, Inc. Balance SheetChanges in Assets
Current Previous Year Year
Change Cash securities 2,000
1,000 Accounts receivable 6,000 5,000 Inventor
y 7,000 8,000 Current assets 15,000 14,000
Net fixed assets 10,000 9,000 Total
assets 25,000 23,000

Current Previous Year Year Cash
securities 2,000 1,000 Accounts
receivable 6,000 5,000 Inventory 7,000
8,000 Current assets 15,000 14,000 Net fixed
assets 10,000 9,000 Total
assets 25,000 23,000
Source Use
-- 1,000 (1,000) 3,000
X X X
Sources of Cash Uses of Cash ? Asset
Account ? Asset Account
Fixed assets if no purchases or sales 9,000 -
2,000 7,000 Depreciation 2,000 Change in
fixed assets 10,000 - 7,000 3,000
13
Eagle, Inc. Balance SheetChanges in Liabilities
and Equity
Current Previous Year Year Accounts
payable 4,000 2,000 Accruals 5,000 4,000 Notes
payable 1,000 2,000 Current
liabilities 10,000 8,000 Long-term debt 6,000
7,000 Total liabilities 16,000 15,000 Common
stock 6,000 6,000 Retained earnings 3,000
2,000 Owners equity 9,000 8,000 Total
liabilities equity 25,000 23,000
Change 2,000 1,000 (1,000) (1,000)
0 --
Source Use
X X X X -- --

Sources of Cash Uses of Cash ? Liability/Equity
Account ? Liability/Equity Account
14
Eagle, Inc. Statement of Cash Flows
Cash Flows from Operations Net income
(NI) 3,000 Adjustments to NI Depreciation
2,000 ? Inventory 1,000 ? Accounts payable
2,000 ? Accruals 1,000 ? Accounts
receivable (1,000) Net CF from operations
8,000 Cash Flows from Long-Term
Investing Acquisition of assets (3,000)
Cash Flows from Financing Activities ? Notes
payable (1,000) ? Long-term bonds (1,000)
Dividend payment (2,000) Net CF from
financing (4,000) Net Change in
cash 1,000 Cash at beginning of year 1,000 Cash
at end of year 2,000

15
Financial StatementsAccounting Alternatives

• In many instances, the same business activity can
  be recorded using one of several accepted
  accounting methodsfor example, LIFO versus FIFO
  for inventory valuation.

16
Financial StatementsTime Dimension

• Balance sheeta snapshot of where the firm is
  at a specific point in time (stock statement).
• Income statement and statement of cash
  flowsshows the results of the firms activities
  over a period of time (flow statement).

17
What Information Do Investors Use from Financial
Statements?

• Net working capital (NWC)
• Current assets - Current liabilities
• Operating cash flow (OCF)
• NOI (1-Tax rate) Depreciation amortization
  expense
• Free cash flow (FCF)
• OCF Investments
• Economic Value Added (EVA)
• NOI (1 - T) - (Invested capital) X (After-tax
  cost of funds)

18
Financial Statement (Ratio) Analysis

• Used to evaluate how financial positions
• Change on a year-to-year basis for a single firm.
• Compare among firms, even if they differ in size.

19
Ratio (Financial Statement) Analysis

• Used by
• Managers inside the firm
• Stockholders and creditorsexisting and
  potentialoutside the firm

20
Ratio (Financial Statement) Analysis

• General categories of analysis
• Liquidity
• Asset management
• Debt management
• Profitability
• Market value

21
Liquidity Ratios
Provide an indication of how well the firm can
meet its current obligations

• Help measure the liquidity position of the firm
• Too little, or too much liquidity could be
  considered a bad sign
• too little liquiditysuggests the firm will have
  problems paying its current obligations in the
  future
• too much liquiditymight suggest the firm is not
  investing its funds wisely

22
Current ratio

• Shows the relationship between current assets and
  current liabilities a higher value suggests
  greater liquidity, and vice versa

23
Quick (Acid Test) Ratio

• Similar to the current ratio, except the value of
  inventories is subtracted from current assets
  (CA) in the numerator inventories represent the
  least liquid of the current assets

24
Asset Management Ratios
Provide an indication of how well the firm
manages its assets (efficiency)

• Show how often the firm is turning over its
  assets to generate funds
• Generally, when assets are not turned over
  quickly enough, it is because sales have slowed
  or current assets, such as inventory and
  receivables, are too high
• If assets are turned over too quickly, it could
  mean that the firm is not producing enough

25
Inventory Turnover

• Shows how many times during a periodfor example,
  one yearthe amount of average inventory is
  turned over due to sales activities.

26
Days Sales Outstanding (DSO)

• Indicates the average time it takes customers to
  pay for credit purchasesthat is, the length of
  time it takes the firm to collect for credit
  sales.

27
Fixed Assets Turnover

• Indicates how efficiently the firm uses its fixed
  assets (excludes current assets) to produce
  revenues

28
Total Assets Turnover

• Similar to the fixed assets turnover, except the
  value of total assets (includes current assets)
  is used.

29
Debt Management Ratios
Indicate how the firms financial position is
affected by the amount of debt it has

• financial leverage refers to the use of debt
• leverage helps to magnify returns, on both the
  positive and the negative sides, because debt
  represents a fixed obligation

30
Debt Ratio

• Indicates the capital structure of the firm
  measures the percent debt used by the firm for
  the purposes of financing assets.

31
Times-Interest-Earned (TIE) Ratio

• Indicates whether the firm generates sufficient
  operating income (not cash) to meet its interest
  obligations each year.

32
Fixed Charge Coverage Ratio

• Like the times-interest-earned ratio, except all
  fixed payments related to financing are included.

33
Profitability ratios

• Indicate how the firms management of its
  liquidity position, assets, and debt has affected
  normal operating activities.

34
Net Profit Margin

• Shows what percent of sales revenues is left
  after expenses related to operations and the
  effects of financing and taxes.

35
Return on Total Assets (ROA)

• Measures the return on investment earned by the
  firm ROA represents a return on all invested
  funds (both debt and equity).

36
Return on Equity (ROE)

• Similar to ROA, ROE is a measure of the return on
  the original funds provided by common
  stockholders (equity only).

37
Market Value Ratios

• Measures that consider the value of the firms
  stock in the financial marketsthat is, how well
  investors perceive that the firm is creating
  value.

38
Price/Earnings (P/E) Ratio

• Indicates how much investors pay for each dollar
  of income generated by the firm.

39
Market/Book Value Ratio

• Indicates the relationship between the selling
  price of the common stock and its book value.

40
Trend and Comparative Analyses

• Ratios should be evaluated
• At a point in time in comparison to a norm, such
  as an industry average, to determine the firms
  current financial position (comparative
  analysis).
• Over time to determine whether the firms current
  financial position is improving or deteriorating
  (trend analysis).

41
Du Pont Equation/Method

• Shows the relationship between the return on
  investment (ROA) and both the total assets
  turnover and the net profit margin so as to give
  more detail where weaknesses or strengths exist.
• For example, if ROA is relatively low, it might
  be due to a low profit margin, a slow turnover of
  assets, or both.

42
Du Pont Equation

43
Uses and Limitations of Ratio Analysis

• Classifying a very large, multidivisional firm
  into a single industry often is difficult.
• Using a single norm, or target, ratio for
  comparisons might be misleading.
• Values on balance sheets are historical costs, so
  ratios might not portray a true picture.
• Seasonality in operations might cause ratios to
  differ significantly at different times of the
  year.

44
Uses and Limitations of Ratio Analysis

• Sometimes firms try to make financial statements
  look better by using window dressing
  techniques.
• If firms use different accounting methods,
  comparisons between firms can be difficult.
• Do not make general conclusions about the firms
  financial position by examining only one or a few
  ratios ratio analysis should be comprehensive.
• The most important part of ratio analysis is the
  judgment used when interpreting the results, not
  the computation of the ratios.